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Development Economics

What is the theory behind programmes of financial liberalisation in developing countries (both internal and external)...

Jamie Benaron

on 5 September 2013

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Transcript of Development Economics

What is the theory behind programmes of financial liberalisation in developing countries (both internal and external), and in what senses can liberalisation go too far?
Prior-Saving Approach
Inflationary Finance Approach (Quantity Theory)
Classical approach to economic development.

Saving (voluntary or involuntary) stipulated to be carried out before investment can take place. Savings will find investment opportunities.
Keynesian Approach
Rejects the idea that saving determines investment.

It stipulates that a dynamic entrepreneurial generation must buck the trend, investing their own resources (via bank loans).

Saving follows through increased output via underemployed resources or through income redistribution from low high propensity saving groups.
Emphasis on role of government monetary expansion, appropriating resources for development through forced saving or via an inflation tax.

Inflation tax: Inflation increases, value of real money decreases, people hold on to money i.e saving provoked (forced saving).
Early financial liberalization thesis is based on weak theoretical foundations.

Evidence has taught that some level of regulation required, strong and developed financial institutions. Healthy economic climate and a gradual liberalization process is needed in order for it to be fully effective.

A cautious approach should be taken when implementing financial liberalization.
McKinnon's View
Saving must occur before investment i.e. investment as a function of savings.
Positive, high real interest rates needed to increase initial saving.
Investment will take place as long as real return on investment exceeds the real interest rate.
There must be a willingness and ability to save.

McKinnon and Shaw both agree that financial deepening is required but to varying extents, and with different chronologies behind saving and investment.
Prior-Saving Approach
Keynesian Approach
Inflationary Finance Approach (Quantity Theory)
3 Analytical Approaches to Economic Development
Shaw's view
Stresses importance of financial deepening.
Emphasises beneficial effect of a high interest rate encouraging saving and discouraging investment in low-yielding projects.
Higher interest rate suggests riskier investments, leads to higher liabilities for banks.
Banks are effectively lending more resources for productive investment in more efficient ways.
Financial repression
Financial repression can take many forms:
Government holds monopoly on banking system.
Controls on number of banks.
Banks may be forced to hold high liquid reserves relative to real assets.
May insist upon credit rationing.
Nominal interest rate may be kept artificially low to the benefit of the government.
What is financial liberalization?
Financial Liberalization is the reduction of the regulations within the financial industry of a given country.
Theoretical models predict FL can promote economic development, by increasing saving, investment, and the productivity of capital.

However FL is not always positive, much evidence, points to destabilizing effects of the process leading in some cases to severe financial crises.
In most cases, developing countries do not have very strong financial institutions.

Therefore it is very important for developing countries to take a gradual and cautious approach when implementing FL programs.
This practice known as ‘financial respression’ was challenged by Goldsmith [1969] and then by McKinnon and Shaw [1973].

They saw it being responsible for low savings, credit rationing and low investment.

Solution was the ‘financial liberalization thesis’ which stresses to let the free market determine the allocation of credit.
The McKinnon/Shaw Approach
Governments should:
Remove interest rate ceilings, leading to the real interest rate returning to its equilibrium level. This leads to low yielding investments being eliminated and overall efficiency of investment being better.
The real interest rate increases, in turn increasing the levels of savings and a higher volume of investment which is important for countries to develop!
Removal of directed credit programs (corruption in developing countries)
Reduce reserve requirements to allow more lending.
Not all good...
Crucially depends on the assumptions of perfect information and perfect competition.

Financial liberalisation can however sometimes go too far. It can lead to severe financial crises.

This happened in Latin America and south east Asia where interest rates exceeded 20 %!

Big bankruptcies ensued and the whole financial system nearly collapsed.
What happened?
Countries removed or loosened controls on companies foreign borrowing, abandoned coordination of borrowing and investments and didn't strengthen bank supervision.

As a result, large amounts of capital flowed into these countries, which led to a credit boom

Westerners invested more in these countries. (can be seen a lot with hot money in deregulated stock markets)

Lead to a bubble. Whole system collapsed.
Lessons learned...
The success of liberalization depends on the countries ability to absorb and utilize the imported know how and technology and also relies on a healthy economic climate. In its absence foreign direct investment may be counter productive.

Countries should not fully commit to liberalization from the word go and should gradually implement it.

Countries need to have strong and developed financial institutions and mechanisms to cope with the change that FL brings.
by Jamie Benaron and Lawson Emanuel
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